Loans on 401(k) Plans a Tax Trap

12 Jun Loans on 401(k) Plans a Tax Trap

Conventional wisdom and prudent financial planning caution against borrowing against a 401(k) retirement account for anything other than emergencies. A post by Dana Wilkinson on Bankruptcy Law Network similarly urges caution in using 401(k) loans to pay off dischargeable credit card debt. Now, given last year’s overwhelming decline in investment portfolio value, people who borrowed against their 401(k) plans for any reason while the market was still strong may have come out ahead, provided they are able to repay the loans as originally scheduled.

Rising unemployment and increasing financial insecurity may translate into increasing numbers of repayment defaults. Default in loan repayment permanently removes the funds from retirement savings. Inability to repay a 401{k) loan as scheduled automatically turns it into a withdrawal, triggering normal income tax liability plus a 10% penalty if the borrower is less than 59 1/2 years old. A bill to waive the 10% penalty in cases of home foreclosure and protracted unemployment was introduced in Congress last summer, but died in committee.

For individuals contemplating bankruptcy, outstanding 401(k) loans can present thorny problems. Since they are not considered debts, the obligation to repay cannot be discharged. Regularly scheduled payments have been rejected as a special circumstance in means testing (In re Mowris, U.S. Bankr. W.D. Missouri, 2008 Bankr. Lexis 760 and more recently in the 9th Circuit with In re Egebjerg, 2009 U.S. App. Lexis 11651), but may be excluded from disposable income in bankruptcy means test calculations and paid outside of a Chapter 13 plan.

This presumes the debtor is still working for the same employer and has enough total income to fund a Chapter 13 plan. If, as is increasingly the case, she has been laid off or has switched employers, the entire loan balance is now due, and failure to pay it within 90 days will create a tax obligation of at least 10% of the outstanding balance. To avoid this, the PSCA (Profit sharing/401k Council of America) suggests using a credit card to pay off the loan balance. To do so on the eve of bankruptcy would almost certainly be challenged as abuse.

The number of people and the amounts of money involved are nontrivial. According to the PSCA, and a review in Kiplinger Magazine discussing 401(k) plan loans, 20% of the 7.4 million participants in 401(k) plans had outstanding loans in 2007, averaging $7600 apiece, or something over 11 billion dollars, some unknown proportion of which is vulnerable to becoming a permanent withdrawal as people lose jobs and their finances deteriorate.

I was admitted to practice in 1978. I am certified as a Consumer Bankruptcy Specialist by the American Board of Certification. I regularly speak on tax and bankruptcy issues at state, regional and national conferences. Years of experience in practice before the Internal Revenue Service and Oregon Department of Revenue have given me the background to resolve a large variety of consumer tax issues.